Frauds, Markets, and Fraud-on-the-Market: The Tortured Transition of Justifiable Reliance from Deceit to Securities Fraud

Abstract

This article examines the reliance element of the securities fraud action. An analysis comparing the economic function of common law deceit to that of securities fraud is used to appraise the current law and to propose refinements. This article argues that neither participants in securities markets nor the society are indifferent to the risk of misrepresentations about securities and that this risk is larger than the risk created by misrepresentations about nonfinancial goods (real goods). Therefore, the fear of misrepresentations about securities is more undesirable than the fear of misrepresentations about real goods. Consequently, the securities fraud action should create stronger deterrence than the deceit action. The fraud- on-the-market presumption of reliance intensifies the deterrence of the securities-fraud action by making class actions more likely to succeed and by allowing larger classes, hence, larger damage awards than under the actual reliance required for deceit liability. Although the economic analysis supports the expansive securities fraud action that the fraud-on-the-market presumption of reliance creates, the presumption also has the important drawback that it may be rebutted if the trader does not "trust the integrity of the market." This rebuttal exposes informed traders to fraud and, therefore, undermines market efficiency. It is easy to overcome this drawback (while retaining the beneficial effects of the rebuttal) by replacing it with the traditional avoidable consequences defense to the causation that reliance shows.